Shining a Light on Shadow Banking

SEC Files Complaint Against Goldman Sachs

People enter the Goldman Sachs headquarters in the Lower Manhattan area of New York on Friday, April 16, 2010 as a security officer looks on.

By David Min | April 16, 2010

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The big news today is that the Securities and Exchange Commission filed a complaint in the U.S. District Court for the Southern District of New York, alleging that Wall Street powerhouse Goldman Sachs defrauded investors in one of its mortgage security deals. In short, the SEC is alleging that Goldman failed to disclose to investors in one of its collateralized debt obligation deals that it had allowed the hedge fund Paulson & Co., in exchange for $15 million in payments, to select the mortgage-backed securities that went into the CDO, even though Paulson was effectively shorting the CDO through the purchase of credit default swaps.

Without commenting on the validity of the SEC’s claims, which have yet to be proven in a court of law (and which may ultimately be settled rather than litigated), the SEC’s complaint is most interesting because of what it says about the lack of regulatory authority currently in place. The SEC is not going after Goldman Sachs for allowing Paulson to both design and bet against a CDO, nor is it alleging that there was anything wrong with Goldman taking a $15 million payment from Paulson. And if you’re expecting that the SEC might charge Paulson for sneakily designing a CDO it was planning to short, you’d be wrong. None of these actions are illegal.

Assuming the allegations in its complaint are true, the only basis upon which the SEC, or any other regulator for that matter, could intervene is insofar as Goldman failed to disclose this whole arrangement with Paulson & Co. That’s the real problem with the status quo, and why we need to enact strong regulatory reform as soon as possible.

This “shadow banking system,” as it has become known, relied on an alphabet soup of various conduits, transactions, and financial securities to finance its lending, including the CDO and CDS that are at the heart of the Goldman Sachs allegations. Under current laws, the general regulatory approach to these types of deals is caveat emptor, with the premise being that the contracting parties are all sophisticated and have deep pockets and should therefore not be protected against the consequences of their own bad decisions, which they can afford to bear.

The problem with this “buyer beware” approach is that it is quite clear that losses in the credit securities and derivatives that make up the shadow banking system today aren’t merely confined to the parties that make these deals. In fact, they have enormous spillover consequences for other parties, including the taxpayer. Because the financial markets are so interconnected today, one financial institution’s failures can quickly spill over to impact many others, causing “runs on the bank” much like the kind that regularly plagued the U.S. banking system prior to the banking reforms of the 1930s.

Let us imagine that Goldman Sachs had done exactly what the SEC had alleged, but had disclosed it in the usual legalese contained in public offering documents, and that the investors had still bought these securities—perhaps because they had not done their due diligence, perhaps because they were still convinced of the credit quality of these securities by Goldman Sachs’s stellar reputation. There would be nothing regulators could do under this scenario to prevent this deal from happening or to punish the parties involved, despite the fact that this type of deal would measurably increase the risk in the financial system through the use of misleading and self-dealing practices.

And that is a fundamental problem with the financial regulatory system today: It treats the core transactions of the shadow banking system as if they were just ordinary bilateral contracts between a buyer and a seller while ignoring the clear externalities that these agreements pose. This laissez faire attitude is completely inappropriate in a world where financial institutions that collapse by virtue of taking on too much risk receive bailouts because of the threats they pose to the larger financial system.

It is clear that we need a holistic approach to the shadow banking system, one that prevents the Goldman Sachses of the world from engaging in these types of duplicitous and conflict-ridden deals that serve no social utility other than to increase profits for a select few, all while significantly increasing systemic risk borne by innocent bystanders and the taxpayer.

The regulatory reform package advanced by Sen. Chris Dodd (D-CT) would improve matters by adding increased transparency to asset-backed securitization. It would also better align the interests of Goldman Sachs with its investors by forcing Goldman to retain some of the risk from that issuance. It is unlikely that Goldman would have created such a toxic stew if it had had to eat its own cooking. It is thus imperative that this bill or legislation like it be passed quickly.

David Min is Associate Director for Financial Markets Policy at the Center for American Progress.